For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

All investing is subject to risk, including the possible loss of the money you invest.

There are few things that destroy an economy as thoroughly as deflation. When prices are expected to fall, spending is delayed. As spending is delayed, prices fall further. In a heavily indebted economy, the real cost of debt goes up. It’s a corrosive spiral that’s presently threatening one of the world’s largest economies, the euro area.

Prices in the euro area have fallen for the past three months and fell 0.3% in February. They’re expected to fall by as much as 0.8% in 2015. This lurch into deflationary territory is mainly explained by the sharp fall in global oil prices. Although the effect on headline inflation is likely to be temporary, there’s a risk that in such fragile conditions falling prices could cause expectations of inflation to slip downward.

Core inflation, which excludes more volatile components such as food and fuel, hasn’t turned negative yet, coming in at 0.6% in February, but this is still significantly below the European Central Bank’s (ECB) mandated target for inflation of just under 2%. This has reinforced the need for the ECB to act.

Back in 2012, Mario Draghi, president of the ECB, famously promised to do “whatever it takes” to save the euro. Through a number of measures and announcements, Draghi managed to stabilize the banking sector and calm capital markets. Even so, the economy has remained in a slough, with demand persistently weak.

In January, the ECB decided to confront more directly the risk of deflation, announcing what seemed a bold program of quantitative easing. The plan is to spend €60 billion a month by buying a mix of government bonds and asset-backed securities (ABS) for 19 months, from March 2015 to September 2016, for a total of €1.1 trillion.

Is it enough? Will it work?

One self-inflicted weakness of the policy is that although bolder than expected and launched at scale, the €1.1 trillion of asset purchases will only take the ECB’s balance sheet to €3 trillion. At around double the size of the pre-crisis balance sheet relative to euro area GDP, this is less than half the four-to- fivefold increase implemented by the Federal Reserve and the Bank of England.

Another reason why the ECB’s quantitative easing (QE) program may not be as effective is the difference in the transmission system. In the United States and the United Kingdom, capital markets provide a large proportion of funding for nonfinancial companies. In the euro area, nonfinancial companies tend to borrow from banks. Given the ongoing capital deficiencies of European banks, and the inherent inefficiencies of a bank-lending model, this is likely to reduce the impact of the program.

Trade tailwind

Fortunately, there are some reasons to be more optimistic. The euro area exports 27.5% of the goods and services it produces, a far higher proportion than the United States. QE should give exports a boost as the euro is expected to depreciate significantly. Already, having fallen 3.5% against the dollar within a couple of days of the announcement of QE, the euro is now hovering around its 12-year low.

Experience has shown that QE raises the value of financial assets and boosts spending via so-called wealth effects. The problem for the ECB is that these effects may not be as large in the euro area as in the United Kingdom and the United States. However, by including asset-backed securities (and also covered bonds), vehicles used to package consumer and small-business loans, the ECB hopes to push the impact of the program deeper into the “real economy” and across a broader field of industrial sectors. The hope is that as the cost of borrowing falls, new investment will become more attractive. Smaller and mid-sized enterprises tend to be more sensitive to interest rates and to be the most dynamic engines of growth.

Breaking the cycle

The ECB’s mandate is price stability, not economic growth. But if inflation is to be returned to target, excess capacity must be squeezed from the system. For this to happen, it may be necessary for fiscal policy to start stimulating growth rather than acting as a drag, as it has during the years of austerity. Indeed, Draghi has personally endorsed the need for a more growth-friendly fiscal approach, pointing to the leeway offered by the new strengthened Stability and Growth Pact (SGP), which constrains government deficits to below 3% of GDP per year.

Again, the euro area’s fragmented nature is an issue. A number of the larger economies continue to run afoul of the SGP rules, including France, Italy, and Belgium. Germany has significant scope for fiscal expansion and was recently encouraged by the International Monetary Fund to pursue stronger public investment, particularly in transport infrastructure. This would likely have only a minor impact on its debt-to-GDP ratio given the likely strong positive growth effect. It’s especially pertinent given Germany’s current low borrowing costs and the likely positive spillover effects for the rest of the euro area. Political resistance, though, remains entrenched and there’s wide support in Germany for maintaining a balanced budget. At this point, policy ideas seem to peter out. A European Union plan to provide €21 billion in seed finance for €315 billion in private sector investment feels like wishful thinking.

Looser monetary and fiscal policies should boost growth in the euro area, but when it comes to generating higher growth over the medium to long term, there’s no doubt that structural reforms are needed. Sustaining strong performance will only be achieved by confronting supply side reforms such as labor laws, obstacles to business formation, bureaucracy, and high taxes. Unfortunately, by suppressing the cost of borrowing, QE creates an environment in which member states can delay reform.

QE is an important policy if we’re to return the euro area to sustainable growth and kill the demon of deflation. But if it’s necessary, it’s not sufficient. Fiscal and structural reform need to be part of the package, too.

Note:

All investing is subject to risk, including the possible loss of the money you invest.

Biola Babawale

Biola Babawale is a London-based economist in Vanguard Investment Strategy Group, where she provides briefing and analysis of economics, markets, and portfolio construction issues for internal and external clients. From 2011 to 2012, she worked at Oxford Economics, an international economic consultancy firm. Ms. Babawale earned an MSc in economic policy from the University College London, and a BSc (Hons) in economics from the University of Warwick.

Comments

Frank K. | May 4, 2015 8:58 pm

The US has fiscal issues greater than Europe. The difference which is a significant US advantage is the dollar’s dominance as the world’s reserve currency. This fact has allowed the US to fund it’s enormous debt despite manufacturing at 13% of GDP, a 62% workforce participation rate, and 50 million on food stamps. When the IMF eventually includes the yuan in the basket of reserve currencies the US and Europe will no longer be concerned with deflation.

Charles C. | May 4, 2015 7:20 pm

Europe has structural problems that must be tackled. Some examples include its generous state health and welfare plans and laws retarding competition.

Hyperinflation can destroy an economy. Review the economic history of Weimar Republic. The Bolsheviks initiated a hyperinflation in Russia after seizing power that brought the economy to its knees thereby reducing the inhabitants to barter.

LLOYD B. | May 1, 2015 11:46 pm

Reading David R comments made me think about his negativism. He thinks that the solution to the economic problems will be a Republican President. Will I am over 80 yrs. of age, and cannot remember when the country had a Republican President without an economic down turn. Of course it was always blamed on the previous president. Good Luck to those negative thinkers.

Manny V. | April 26, 2015 4:11 am

Now that savings interest has gone negative in Europe with Denamrk issuing negative mortgages , the Swiss bankis demonizing savers..and cash , as keeping out the bank is safer..and paying banks to borrow leaving savers ie pension funds liable to banks for holding their money .just what does vanguard intend to do or is doing to forestall this nightmare from beaching itself on our funds.
Seems to me the strict controls on cash lately here in the states and warning not to keep in safety deposit boxes has less to do with terrorism than banks covering their behinds and this interest shortfall, and if Vanguard has to pay the banks to hold our money
Truth be told its getting to make more sense to pull it out and keep it in a shoebox

Wilbur B. | April 9, 2015 8:44 pm

The nations looking into the ABYSS of deflation share one demographic characteristic: None of them have enough births in their populations each year to replace the citizens who die. This is NOT true of India, sub-Saharan Africa and most Islamic nations. If a country does not have a population anticipating children and future adults having related genetic structures to themselves, what do they have to inspire them to build and expand?
Displays of ostentatious wealth, such as amassed by the creators of Microsoft, Tweets, etc. seem not to be sufficient inspiration to keep them spending for “stuff”.
The USA is marginal in this regard. Replacement ratio is about 2.11 live births per woman in the age range from 15 to 45.
Wilbur

Joseph L. S. | April 9, 2015 6:49 pm

What really destroys economy’s is GIVING people money for sitting home on their butt, Greece is a perfect example, We in the US are going that way, people being paid basically for their vote, not for their work efforts.

Obama is the main culprit, he knows the ne’er do wells & the Illegals will vote DEMOCRATIC if you keep paying them off, up to 43% & rising.

Economics is NOT brain surgery or rocket science, when people earn enough to have discretionary spending money they buy stuff, so the manufacturer, supplier & retailer all profit, SIMPLE.

David R. | April 15, 2015 8:08 am

I think it’s the world in general. People have lost their pride and will do anything to get farter ahead with the least amount of effort. Quality prices for substandard work. As long as we have leaders that are not qualified, in our country and others, we will keep loosing our back up funds. As they say, you can’t get blood from a turnip. The only place to get money is from those that have it. Those that work hard will have to pay for those that don’t. Doesn’t matter if it’s health care or food. Nobody spends other peoples money wisely. I agree with Joseph that we need to police our freebies. I hope we get a Republican leader that is willing to do what is right for our country and our allies.

What's your opinion?

Vanguard welcomes your feedback on this blog, but please read our commenting guidelines
first. Comments will be published at our discretion. Questions or comments about your Vanguard investments or customer-service issues? Please
contact Vanguard directly. Opinions expressed in blog comments are those of the persons submitting
the comments, and don't necessarily represent the views of Vanguard or its management.

You might like

Twitter

For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

All investing is subject to risk, including the possible loss of the money you invest.